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As President Obama and Congress speed toward each other on a world-rattling collision course, the European Central Bank (ECB) is also replaying its own version of "political chicken" with member states in the European Union these days. At issue is the shape of the common currency's necessary institutional reforms. The core concern is about who pays the bill for rescuing the euro area's undercapitalized banking system—investors, national taxpayers, or the euro area as a whole (e.g., Germany)—as the parties struggle to create a new banking union.
Under measures that have already been agreed, the ECB is to take over as the new supranational banking regulator for the largest banks in the euro area with the creation of a new Single Supervisory Mechanism (SSM). Before assuming its new responsibilities, the ECB must conduct an asset quality review (AQR) in collaboration with the European Banking Authority (EBA). The AQR is to be complemented by a stress test of the euro area banking system like those undertaken in the United States in 2009. This is in fact the third stress test of EU banks since 2010. Officials hope that the unlike the others, this one will finally restore the banks' market credibility, reopen their access to interbank lending markets, and lower their cost of funding. The ultimate goal is to wean them off ECB liquidity and deliver much needed monetary easing in the euro area periphery. Their premise is that healthier banks will be more willing and able to lend at lower interest rates.
But there is a catch, because of widespread concern about possible gaping holes in bank balance sheets that may be too big for some debt-burdened national governments to fill. A further concern is that the ECB might avoid exposing such weakness and instead show the same forbearance that national banking regulators have shown in the past. To alleviate this concern, Europeans are discussing a possible new "fiscal backstop" among member states ahead of the AQR/stress test results. No doubt the ECB would prefer such a step, but any assumption that it would water down its stress test to spare member states the cost is misplaced.
The ECB, after all, remains the most politically powerful central bank in the world. It has shown its willingness to force the hands of governments in a crisis and indeed overrule national banking authorities. That is why it has been given the new bank regulatory responsibilities. The ECB knows that bungling its role as banking regulator would also ruin its reputation as a monetary policymaker. Its interest is to ensure that the AQR/stress test process is credible.
As before in the euro area crisis, the ECB will not hesitate to use adverse financial news and market volatility to strengthen its leverage to force member states to create the backstop and recapitalize their banks, steps they are now resisting. Earlier in the euro crisis the ECB exerted such pressure by withholding its approval of large-scale government bond purchases. Only in December 2011 did the bank provide long-term cheap liquidity to euro area banks (the so-called long-term refinancing operations, or LTROs), when market pressures forced member states to sign the Fiscal Treaty. The ECB therefore has a history of fomenting market volatility to get things its way. It is likely to do so again.
Even a rigorous and transparent AQR/stress test might reveal that any hole in the euro area banking system will be manageable—€50 billion to €60 billion, for example. Such an amount could be supplied by private markets without much fuss. If that happens, the ECB would still look good.
More likely, however, the stress test will reveal that a number of euro area banks are insolvent. Following the example of Cyprus, shareholders and creditors of insolvent banks will have to bear part of the cost for rescues—"bailed in," as the term is known. Like Bear Stearns, Merrill Lynch, Wachovia, and other institutions in 2008, insolvent banks may have to be taken over or consolidated, posing little risk to member state governments.
Banks that are solvent but undercapitalized may fail to attract sufficient new private capital. To some extent, this is a hypothetical problem. Banks in this category, being solvent, should be able to raise enough new equity capital from private sources to pass the stress tests, even if shareholders are wiped out. Shareholders would protest, but, faced with a robust regulatory approach from the ECB, they would probably proceed with new rights issues even at extremely diluting price levels.
Many experts say they fear1 more volatility because of these factors, and perhaps even another downward spiral for the European banking system, pulling the economy into another recession. But even if euro area member states do not agree on a credible fiscal backstop, the ECB's crisis strategy is there to exploit. Moreover, if a new crisis threatens to get out of hand, the ECB can restore its lavish support for euro area banks and sovereigns. Risks to its strategy are hence manageable.
Despite the separation of the ECB's monetary policy and its new banking regulatory responsibilities, the coming 12 to 18 months will bring together a relationship between its non-standard monetary policy initiatives and the stress test process. Why, for instance, would the ECB provide another LTRO or other new non-standard liquidity support to euro area banks before the AQR/stress test results are ready? Providing such a back would merely let bank shareholders and member states' governments' shirk their responsibilities to buttress bank capital levels. Political moral hazard lurks large here.
It can even be argued that for the ECB, the biggest reputational risk lies in a potentially botched banking sector review. The last three-month average (April to June 2013) for the euro area's harmonized inflation of consumer prices (HICP) is 1.4 percent, well below the target of "close to but below 2 percent." But fears over the AQR/stress test would make it rational for the ECB governing board to maintain this deflationary bias by allowing its inflation target to be undershot. This would deny member states with monetary policy "gifts" in the months ahead, before they take action to fix their banks
Since 2010, the ECB has generally prevailed in its clashes with euro area governments. Expect the game of chicken to continue, but expect volatility as a result.
Note
1. I am deeply indebted to my colleagues Nicolas Véron, Douglas Rediker, and Angel Ubide for constant and always fruitful debates of these issues.
